Monday, December 01, 2003
FACTUAL
More On The Two Asian Giants
On profitability, markets and competition
SAUMITRA CHAUDHURI
Jonathan Anderson of UBS Investment Research, in verbal comments during his presentation on capital controls at the IMF-sponsored conference on India and China, said something that was quite startling. Nothing to do with capital controls, but on manufacturing profits. Anderson, who is greatly familiar with China, said that Chinese (private and joint sector) companies are rather profitable with average return (profit before interest and tax) on capital employed (ROCE) of 30 to 35 per cent.
Arvind Panagariya intervened to note that the number of players were large. For instance in two wheelers, unlike India's handful of companies, as many as 30 companies thrive in China. Anderson attributed the exceptionally high profitability, which co-existed with competition, upon "very buoyant demand".
If a particular line of business has an ROCE of 35 per cent, then with a modest gearing of 1:1, that is equal part equity and debt, the return on equity would be very high, the exact magnitude depending on interest and tax rates. If 10 per cent be the interest rate, then pre-tax return on equity wo uld be as high as 60 per cent. If 35 per cent be the tax rate, the post-tax profit as a proportion of equity would be 39 per cent. But tax sops and/or inventive tax avoidance could make returns on equity approach the heavenly levels of 60 per cent. Now, with conditions that generate that kind of profit, businesses should be falling over each other investing. Exactly what seems to be happening.
The mystery is what keeps profits at such stratospheric levels? For a short period in the mid-1990s, it was not uncommon to find Indian companies with ROCE in the 30 per cent range. Which was soon to fall back by half. We know what the factors were that swept away this false dawn of high profitability. Heightened competition from domestic players, as well as from imports, plus declining rates of inflation. But average import tariffs in China, at least since 1997, have been significantly lower than those in India. The number of players in each line of domestic business in China appears generally to be much the higher. Inflation in China (consumer price index) had been virtually non-existent, and very much lower than in India. So, how is that profitability of this magnitude characterises so much of Chinese manufacturing?
Could it be Anderson's "buoyant demand"? Quite the opposite actually. In an expanding market there is a clear trade-off by way of market share - between today's profits in a smaller market and tomorrow's in a much-expanded market. Competitors slash at each other's prices, organise give-aways to customers and selling agents, all in an effort to enlarge market share. Since everybody does it, this mutates from an aggressive strategy to a defensive one. The idea is that in the end, some combination of better technology, deeper pockets and superior organisation should carry the day. In fact, it generally does not - since there are too many players with the attributes to survive. The outcome is that the few who do last out the initial frenzy of competition, have to be content with fairly modest profitability and suffer the collective punishment of forever being strung out between the desire to raise prices and the fear of losing market share. Some of course do better than others. Technology, brand, distribution, financing and service networks, all help to wring profits out of the heartless stone of competition.
But a serpent lurketh in this Eden of imperfect capitalist markets, and its name is Cartel. If producers collude to avoid those bruising price wars - maybe make those small price cuts in nice co-ordination - then it is possible to sustain unnaturally high profits. Capitalist societies do not like cartels and take steps to break them up - thus it was that Standard Oil of New Jersey met its demise. The conventional idea of cartels is that of a handful of players who have come to dominate the market and fix prices. A cartel with 30 players is bit of a stretch. Unless, it is, that we factor in the "invisible hand" - not that of Adam Smith but of an all-powerful State that has little patience with the wasteful ways of the so-called free market.
The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)
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